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Wall Street can't hold back Vanguard's low-fee ocean

(Bloomberg Gadfly) -- Vanguard is bringing down the cost of investing and there’s nothing Wall Street can do about it despite its best efforts.

Some financial firms are making it more expensive ― and in some cases impossible ― for their clients to buy Vanguard mutual funds and ETFs, according to a report in the Wall Street Journal on Sunday.

Fidelity, for example, will charge “some new corporate customers that hire the firm to run their 401(k) plans a fee of 0.05 percent on assets invested in Vanguard funds.” TD Ameritrade dropped 32 Vanguard funds from its commission-free lineup of ETFs, and Morgan Stanley banned “its financial advisers from selling clients new positions in Vanguard mutual funds.” (Disclosure: My asset-management firm uses TD for custody and Vanguard funds in some accounts, including my own.)

It’s a naked ploy to prop up their fees and it won’t work. This isn’t the first time that Wall Street is on the wrong side of history. When Vanguard founder Jack Bogle introduced the first index fund in 1976 ― the iconic Vanguard 500 Index Fund ― Wall Street famously dubbed it “Bogle’s Folly.”

Four decades later, Bogle has the last laugh. Vanguard took in a record $236 billion in net assets in 2015 and an additional $305 billion in 2016. In November, outgoing CEO Bill McNabb said that the firm was on pace to collect an additional $350 billion in 2017. Vanguard is now the second-largest money manager in the world with roughly $5 trillion in assets ― multiples bigger than Wall Street firms such as Goldman Sachs and Morgan Stanley.

It’s no accident that investors are flocking to Vanguard. Bogle predicted that most Wall Street stock pickers wouldn’t keep up with his humble index fund net of their princely fees. He was right. According to S&P Dow Jones Indices’ most recent SPIVA Scorecard, only 7% of U.S. large cap mutual funds beat the S&P 500 over 15 years through June 2017, the longest period reported by S&P.

And those are the funds that managed to survive. Consider that only 82 U.S. large- and mid-cap mutual funds that predate Vanguard’s 500 Index Fund are still operating, according to Morningstar data. Since-inception returns are unavailable for two of them.

I looked to see how the other 80 fared relative to the S&P 500. I found that 43% of them beat the index since their respective inception dates. In other words, even if investors had the foresight to pick the most enduring mutual funds among the thousands that have come and gone over the decades, they still would have been better off simply buying the market more often than not.

The pressure that financial firms are feeling is just the beginning. Investors are increasingly focused on fees, and the problem for Wall Street is that there’s nothing it can do that Vanguard can’t do more cheaply.

In fact, Vanguard is increasingly encroaching on Wall Street’s turf. The firm is expected to roll out a suite of funds in the first quarter that replicate investment styles used by Wall Street stock pickers at a fraction of the cost. Those styles include value, momentum, quality, liquidity and low volatility for just 0.13% a year.

There’s no going back. If Wall Street wants to compete, it will have to lower fees. Some firms are already doing it. Merrill Lynch launched a discount broker and robo-adviser last year. Goldman Sachs introduced low-cost smart beta ETFs in 2015, the cheapest of which charges just 0.09% a year.

It’s not just Wall Street that’s due for a pay cut. According to data cited by blogger Michael Kitces, the median advisory fee for investors with less than $250,000 is 1% a year. That’s in addition to a median expense ratio of 0.85% for the funds that financial advisers recommend. Those fees decline only modestly for wealthier investors, adding up to 1.5% a year for investors with $1 million to $2 million. Vanguard’s new CEO Tim Buckley reminded advisers attending the Inside ETFs conference last week that they, too, will have to lower fees or look for other work.

Bogle likes to say that when it comes to investing, “you get what you don’t pay for.” Wall Street firms can no longer pretend that isn’t true. If they do, their growing herd of former clients will be sure to remind them.